According to conventional financial theory, the world and its participants are, for the most part, rational “wealth maximizers”.
However, there are many instances where emotion and psychology influence our decisions, causing us to behave in unpredictable or irrational ways.
Behavioral finance seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.
When we want to describe finance, we are talking about the type of finance that is based on rational and logical theories, such as the Efficient Market Hypothesis (EMH), which assumes that people, for the most part, behave rationally and predictably.
Theoretical and empirical evidence suggests that EMH and other rational financial theories did a respectable job of predicting and explaining certain events.
However, as time went on, academics in both finance and economics started to find anomalies and behaviors that couldn’t be explained by theories available at the time.
While these theories could explain certain “idealized” events, the real world proved to be a very messy place in which market participants often behaved very unpredictably.
One of the most rudimentary assumptions that conventional economics and finance makes is that people are rational “wealth maximizers” who seek to increase their own well-being.
According to conventional economics, emotions and other extraneous factors do not influence people when it comes to making economic choices.
In most cases, however, this assumption doesn’t reflect how people behave in the real world.
The fact is people frequently behave irrationally.
Consider how many people purchase lottery tickets in the hope of hitting the big jackpot.
From a purely logical standpoint, it does not make sense to buy a lottery ticket when the odds of winning are overwhelming against the ticket holder.
Despite this, millions of people spend money on this activity!
These anomalies prompted academics to look to cognitive psychology to account for the irrational and illogical behaviors that modern finance had failed to explain.
Behavioral finance seeks to explain our actions, whereas modern finance seeks to explain the actions of the “economic man” – Homo Economicus.
Although behavioral finance has been gaining support in recent years, it is not without its critics.
Some supporters of the efficient market hypothesis, for example, are vocal critics of behavioral finance.
The efficient market hypothesis is considered one of the foundations of modern financial theory.
However, the hypothesis does not account for irrationality because it assumes that the market price of a security reflects the impact of all relevant information as it is released.